76. Financial Crisis
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⚫ Financial crisis broadly refers to;
⚫ disruptions in financial markets causing constraint to the flow of
credit to families and businesses and,
⚫ consequently having an adverse effect on the real economy of
goods and services.
⚫ The term is generally used to describe a situation in
which;
⚫ investors unexpectedly lose a substantial amount of their
investments, and
⚫ financial institutions suddenly lose a significant proportion of
their value.
⚫ Financial crises include, among others;
⚫ stock market crashes,
⚫ financial bubbles,
⚫ currency crises, and
⚫ sovereign defaults.
78. The Subprime Mortgage Dilemma
It is believed that every economic crisis is the product of cheap
credit; low interest rates create demand for loans that cannot be
repaid when interest rates subsequently rise.
Lower interest rates in the United States meant that mortgages
became more affordable and more in demand.
Chapra (2009) points out that in such an environment “loan
volume gained greater priority over loan quality” and ordinary
investors were enticed to live beyond their means.
As interest rates began to rise, new-home affordability and the
ability to repay existing loans have sharply plummeted.
The problem was exacerbated by the complexity of products
that have been created by intermediary players that sought to
pass the entire risk of default to the final purchasers.
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84. Implications of the Global Financial Crisis
A limited subprime mortgage impasse in the US real estate grew
to be the world’s biggest financial crisis since the 1930s.
Every section of the globe have been some how affected by the
crisis, as it has hit almost every sector of the world’s economy.
World economies have yet to devise prudent strategies to deal
with the crisis.
Conventional financial institutions, by and large, were the first to
feel the full impact of the crisis they had initiated.
The year 2008 was packed with unparalleled events that have
created mass uncertainty, such as:
– a sharp decline in global equity markets,
– the failure or collapse of numerous global financial institutions,
– governments of a number of industrialized countries allocating in
excess of $7 trillion for a bailout and liquidity injections to revive their
economies,
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107. Decision Dilemma—Take a Lump Sum or
Annual Installments
❑A couple Won a Lucky Draw.
❑They had to choose between
a single lump sum $104
million, or $198 million paid out
over 25 years (or $7.92 million
per year).
❑The winning couple opted for
the lump sum.
❑Did they make the right
choice? What basis do we
make such an economic
comparison?
108. Opportunity Cost
Opportunity cost = Alternative use
– The opportunity cost of money is the interest rate that would be
earned by investing it.
– It is the underlying reason for the time value of money
– Any person with money today knows they can invest those funds
to be some greater amount in the future.
– Conversely, if you are promised a cash flow in the future, it’s
present value today is less than what is promised!
109. Choosing from Investment Alternatives
Required Rate of Return or Discount Rate
You have three choices:
1. $20,000 received today
2. $31,000 received in 5 years
3. $3,000 per year indefinitely
To make a decision, you need to know what
interest rate to use.
– This interest rate is known as your required rate of
return or discount rate.
110.
111. Time Value of Money
❑Money has a time value
because it can earn more
money over time (earning
power).
❑Money has a time value
because its purchasing power
changes over time (inflation).
❑Time value of money is
measured in terms of interest
rate.
❑Interest is the cost of
money—a cost to the borrower
and an earning to the lender
112. The Time Value of Money
•One of the most important principle in finance
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$1 today
Relationship
$1 future
Present Value
Future Value
Interest is the factor contributing to Time Value of Money
Simple Interest= Principal x Interest rate x time period
= Po(i)(n)
120. Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the principal
borrowed (lent).
Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
Types of Interest
121. Formula SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
Simple & Compound Interest Trends
DOLLARS
Simple Compound
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
122. Simple Interest Future Value
Principal(Po)=$1000
Interest (i) = $10%
Time (n) = $5 Years
Interest =?
Future Value=?
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123. Simple Interest Present Value
Future Value=$7500
Interest = $10%
Time = $5 Years
Interest =?
PRESENT Value=?
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124. Simple Interest Present Value
Po+(Po *n*i)=7500
Po +(0.5 Po)=7500
1.5 Po =7500
Po =7500/1.5
Po =5000
Principal= 5000
Interest=Fv-Pv
Interest=7500-5000= 2500 19
130. Double Your Money!!!
We will use the “Rule-of-72”.
Quick! How long does it take to double
$5,000 at a compound rate of 12% per
year (approx.)?
Approx. Years to Double = 72 / i%
72 / 12% = 6 Years
[Actual Time is 6.12 Years]
131. Types of Compounding Problems
There are really only four different things you can be asked
to find using this basic equation:
FVn=PV0 (1+k)n
▪ Find the initial amount of money to invest (PV0)
▪ Find the Future value (FVn)
▪ Find the rate (k)
▪ Find the time (n)
132. Types of Compounding Problems
Solving for the Rate (k)
Your have asked your father for a loan of $10,000 to get you started in a
business. You promise to repay him $20,000 in five years time.
What compound rate of return are you offering to pay?
This is an ex ante calculation.
FVt=PV0 (1+k)n
$20,000= $10,000 (1+r)5
2=(1+r)5
21/5=1+r
1.14869=1+r
r = 14.869%
133. Types of Compounding Problems
Solving for Time (n) or Holding Periods
You have $150,000 in your RRSP (Registered Retirement Savings
Plan). Assuming a rate of 8%, how long will it take to have the
plan grow to a value of $300,000?
– This is an ex ante calculation
FVt=PV0(1+k)n
$300,000= $150,000 (1+.08)n
2=(1.08)n
ln 2 =ln 1.08 × n
0.69314 = .07696 × n
t = 0.69314 / .076961041 = 9.00 years
134. Types of Compounding Problems
Solving for Time (n) – using logarithms
You have $150,000 in your RRSP (Registered Retirement Savings Plan).
Assuming a rate of 8%, how long will it take to have the plan grow to a
value of $300,000?
– This is an ex ante calculation.
FVt=PV0 (1+k)n
$300,000= $150,000 (1+.08)n
2=(1.08)n
log 2 =log 1.08 × n
0.301029995 = 0.033423755 × n
t = 9.00 years
135. Types of Compounding Problems
Solving for the Future Value (FVn)
You have $650,000 in your pension plan today. Because you have retired,
you and your employer will not make any further contributions to the
plan. However, you don’t plan to take any pension payments for five
more years so the principal will continue to grow.
Assuming a rate of 8%, forecast the value of your pension plan in 5 years.
– This is an ex ante calculation.
FVt=PV0 (1+k)n
FV5= $650,000 (1+.08)5
FV5 = $650,000 × 1.469328077
FV5 = $955,063.25
136. Types of Compounding Problems
Finding the amount of money to invest (PV0)
You hope to save for a down payment on a home. You hope to
have $40,000 in four years time; determine the amount you
need to invest now at 6%
– This is a process known as discounting
– This is an ex ante calculation
FVn=PV0 (1+k)n
$40,000= PV0 (1.1)4
PV0 = $40,000/1.4641=$27,320.53